ETF criticisms don’t stand up to scrutiny

Philip Salter
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EVEN prior to Kweku Adoboli’s UBS fraud, there was plenty of mud being slung at exchange-traded funds (ETF) – almost all unjustifiable. UBS’s rogue trader is irrelevant to the concerns of retail investors, for whom ETFs offer a cheap and liquid way to track many indexes.

In the case of the UBS fraud, the problem was essentially a failure of internal controls. Adoboli was positioned unhedged in index futures, booking dummy ETF trades into the system with settlement dates far into the future. Considering some of the outcries against ETFs, it is ironic that Adoboli’s fraud rested on not using ETFs to hedge his positions.

As Ben Johnson, director of European ETF research with Morningstar, says “the responsibility lies with the person not the instrument.” In response, banks are busy implementing new controls to validate trades. But while banks try to learn the right lessons from the latest rogue trader, investors and regulators should make sure they don’t learn the wrong ones.

An ETF can be physically-backed – actively holding the asset, or assets, of the index it is tracking – or synthetic, mimicking the index through derivatives. There has been a debate rumbling, which regulators are entering, pitching physical against synthetic ETFs, with defenders of the former often critical of the complexity and counterparty risks of synthetics, while the defenders of synthetics complain that physically-backed ETFs underperform their index to a greater extent. The criticisms are red herrings. Especially complex ETFs are reserved for institutional investors, while the most complex in the retail space come with adequate health warnings. Investors are faced with the same choices they have in every other purchase they make: take a risk, trust a professional or learn for themselves.

Counterparty risk of ETFs and the broader issue of the property rights of who owns what should a bank go bust should indeed concern investors – especially given the parlous state of Europe’s banks. But once again, this isn’t a problem particular to ETFs. It is time investors started thinking about how exposed all their wealth is to the collapse of any bank.

The main advantage of ETFs is simply that they are nearly always cheaper than funds. Caroline Shaw of Courtiers also points out ETFs offer advantages in their ability to trade at any time during the day. She thinks that given the increasing range of ETF products available, it is becoming more viable for investors to use them in place of funds. She says “there is certainly an argument that a low cost ETF is a good idea in a heavily analysed market, such as the S&P 500.” However, because not all asset classes and sectors are available through tracking an index, she says “there are certain areas where manager expertise is essential – such as, small cap investments, bricks and mortar property and private equity.”

ETFs are a broad church – some are very conservative, tracking their index closely, while others, particularly commodity ETFs, don’t. The former isn’t necessarily better than the latter – the point is to understand what it is the ETF is supposed to do, how it plans to do it and whether it is actually managing this in practice.

ETFs don’t offer alpha, but then most fund managers don’t deliver it. ETF providers already offer all the information necessary for investors to make informed decisions. As such, the recent and ongoing haranguing of ETFs should be tempered, while concerns about their complexity and counterparty risk should be expressed with reference to the facts and situated within broader investment debates on risks versus rewards.

Don’t be put off by lazy headlines decrying ETFs – they should form a crucial pillar of everyone’s investment strategy.